Commentary Archive 2014

Commentary Archive 2014 background

Commentary Archive 2014

Disclosure

Performance results are based on estimates. Although the information contained in the commentary sections have been obtained from sources we believe to be reliable, the accuracy and completeness of such information and the opinions expressed herein cannot be guaranteed. Past performance is not necessarily indicative of future results. Different types of investments involve varying degrees of risk.

Fourth Quarter 2014

  • The Large Cap Institutional Equity composite gained 2.61%, underperforming the Russell 1000 Growth benchmark by 2.17%.
  • The All Cap Growth Equity composite gained 4.50%, underperforming the Russell 3000 Growth benchmark by 0.67%.
  • The Mid Cap Equity composite gained 1.17%, underperforming the S&P 400 Total Return benchmark by 5.18%.
  • The Latin America Equity composite lost 9.13%, outperforming the Russell Latin America benchmark by 3.78%.
  • The Growth & Income Equity composite gained 3.05%, underperforming the S&P 500 Total Return benchmark by 1.88%.

Hanseatic Market Commentary

The U.S. stock market delivered another good performance year in 2014; large, mid and small cap stocks were up about 13%, 10% and 5% respectively. Outside the U.S., virtually all country stock markets were negative for the year with the exception of India (+20%) and China (+8%). Russia was down 49% with much of that damage near the end of the year in concert with the downward spirals in the ruble and crude oil.

2014 demonstrated the resilience of the U.S. stock market that is in the midst, in our view, of a secular bull market that is characterized by above-average returns and generally lower volatility and risk. The 2014 market navigated a minefield of events and risks that included a very weak first quarter GDP reading of -2.1%. Bad weather had a significant negative impact in the early part of the year disrupting production, construction and generally being a drag on all manner of retail activity. Then came Russian invasions, Mideast chaos, Ebola and the U.S. elections. All these events, along with the uncertainty of the Fed ending QE, could have derailed a less resilient market. One significant negative aspect of 2014 was the underperformance in small cap stocks which lagged the S&P 500 by nearly 10%. The explanation is likely that valuations in small stocks became relatively rich after an especially strong 2013.

The positive economic growth trends, especially over the last three quarters of 2014, will likely continue into 2015. The unemployment rate dropped from 6.7% in January 2014 to 5.8% in December 2014. An impressive 321,000 jobs were added in November 2014 at the same time workweek hours reached their highest level since before the recession. Also, the outlook for the U.S. consumer is more positive than any time in the last several years. The cratering in energy prices translates to both lower gasoline prices and heating bills. At the same time these costs are falling, incomes are rising in the form of higher hourly wages and increased weekly hours.

As a result of the robust economic growth the Fed is widely expected to raise interest rates for the first time since June 2006. There seems to be a growing confidence under Janet Yellen's stewardship the Fed will successfully steer away from the easy money policies of the past seven years. Stocks have historically performed well in the months leading up to interest rate increases. In the twelve months prior to the 1994, 1999 and 2004 initial rate increases, the S&P 500 scored double digit positive returns. Given that inflation is low and the absolute level of interest rates is extremely low, raising rates would signal confidence that the economic recovery is sustainable. So, initially at least, the change in the Fed's posture should be a positive for the market, though it may induce some volatility. The risks will come if magnitude, timing or the rate hikes are contrary to expectations. It is also worth noting that initial rate hikes have historically come only about halfway through economic cycles and well before bull markets have ended.

In July 2014, the spot price for WTI crude oil was $107 per barrel, and energy was the strongest equity market sector. In early 2014, Bloomberg's survey of 28 forecasters gave a prediction of $105 as the average price for crude oil in 2014, down from $108 in 2013. The most bearish prediction, from the Citibank forecaster, was $75. Now, in January 2015, crude oil futures have dipped below $50 per barrel and the Oil Service ETF is 45% off its peak. So much for wasting time on energy price forecasts. As with the stock market, the variables are much too complex and dynamic. At this point, the oil price decline is the third steepest correction since 1982, exceeded only by the 2008 and 1986 oil bear markets. In both of these instances, a glut of oil stemmed from a collapse in global demand. The glut of oil produced in the U.S. has been the main driver of the current decline, but weak global demand has also played a role. The selloff gained momentum when Saudi Arabia decided not to cut production at the November 2014 OPEC meeting. A downward spiral in energy costs of this magnitude is obviously going to have significant impacts for both corporate earnings and different parts of the economy. The obvious winner is the consumer as lower prices at the gas pump and cheaper home heating bills help boost discretionary income. Manufacturers benefit from cheaper fuel and raw materials, and in general, transportation companies are beneficiaries. There are losers, of course, that accompany a sharp drop in energy prices. The most immediate negative impact is on oil producers and the ecosystem that serves them, including equipment and service providers. There will also be a drag on some parts of the industrial sector who have benefitted from substantial investment by energy companies.

As for the 2015 stock market, there seems to be widespread consensus among strategist that the S&P 500 will end the year up 5-10%. Although we steadfastly abstain from any part of the forecasting business, the consensus view is rational, though somewhat unnerving to our contrarian sensibilities. The current bull market can reasonably be said to be in the mature stage as it is now the fourth longest and fourth strongest on record according to Bespoke. However, bull markets end not on maturity but with complacency and ultimately recession. One of the more remarkable aspects of this bull market is that investors have been so reticent; there is none of the euphoria that one would expect this far into an historic bull market. The Yale one-year confidence chart shows that both individual and institutional investors have low confidence about the outlook for the stock market, over the course of 2015. So, at least by this measure, the "wall of worry" that has been integral to this bull market since 2008 is still intact.



"Stock Market Confidence Indices." Yale School of Management. Web. 2014

Hanseatic Composite Commentary

LARGE CAP INSTITUTIONAL EQUITY

The Large Cap Institutional Equity composite's fourth quarter 2014 underperformance derived largely from the panic sell-off in stocks during the first half of October and the historic recovery to new highs over the subsequent two to three weeks. Two factors penalized performance. First, the sharp decline engaged either the sell or position sizing reduction disciplines for a number of portfolio stocks, some of which then recovered as stocks made new highs. Second, the portfolio had a moderate risk-off posture in concert with the signal from the Hanseatic Defensive Index. This also detracted from performance as the market and Healthcare/Industrial stocks were particularly strong in the weeks following the early October panic. The portfolio was also moderately underweight Industrials when the transportation stocks rallied in response to the sharp drop in fuel costs. The portfolio is well balanced coming into 2015 with a small defensive posture and the ability to adapt as sustainable leadership emerges.

ALL CAP GROWTH EQUITY

The All Cap Growth Equity composite's fourth quarter 2014 underperformance was derived primarily from the correction in select Healthcare stocks and the strong benchmark performance in Industrials. The correction in Healthcare, specifically biotech and pharmaceuticals, was not surprising considering the strong performance in these stocks in the first three quarters along with some year-end profit taking. Industrial stocks were beneficiaries of the sharp drop in fuel and raw material costs. Because of the risk-off orientation of the Hanseatic Defensive Index at portfolio inception, the portfolio was not oriented to benefit from the historically sharp rally in stocks in general and Healthcare/Biotech stocks in particular during the last half of October. Consumer Staples contributed positively both on an absolute and relative basis during the quarter as well as being underexposed to Energy.

MID CAP EQUITY

The Mid Cap Equity composite's fourth quarter 2014 underperformance was derived from the whipsaw in October, poor portfolio performance in Materials, and strong benchmark performance from Financials. The whipsaw in October was material as noted in the October monthly market commentary. Several portfolio stocks violated the Hanseatic primary sell discipline in October. The Hanseatic proprietary Defensive Index indicated that an early stage risk-off market posture was prudent. The portfolio team actively increased cash early in the month, however, in the second half of October, the market rebound was unusually sharp. The increased cash negatively impacted October performance which had a material impact on the entire quarter. Last, benchmark Financial stocks broadly performed well during the quarter and the portfolio's underweighting to this sector detracted from performance during the quarter. The portfolio is almost fully invested coming into 2015 and the portfolio team is monitoring Financials and the Healthcare exposure closely, primarily biotech and pharmaceutical. Consumer Discretionary continues to be strong and we will adapt the portfolio as other sustainable leadership emerges.

LATIN AMERICA EQUITY

The Latin America Equity composite's fourth quarter 2014 outperformance was bittersweet. Outperforming by almost 4% during a quarter would normally be more than notable, but it is not without some measure of disappointment on an absolute basis. Emerging markets in general have experienced volatility from risks that are beyond the scope of normal equity market dynamics, which can be challenging for active portfolio management. The portfolio team took a prudent approach in the face of the recent volatility and took benchmark, or below, positions in the largest benchmark weighted stocks during this period of uncertainty. Had the election in Brazil gone a different direction or the OPEC news not been as aggressive, the outcome could have possibly been very different. It was the most prudent decision at the time based on the risk/reward probabilities of the situation. The unwinding process has begun and will continue as indicated by the Hanseatic model in these larger weights. Eight out of ten benchmark sectors performed negatively during the quarter; no surprise considering the OPEC announcement in late November and subsequent material decline in energy prices. Cash is higher than normal and will remain until there are new stocks that meet the Hanseatic primary or supplemental buy disciplines.

GROWTH & INCOME EQUITY

The Growth & Income Equity composite's fourth quarter 2014 underperformance was derived from poor absolute and relative performance in Energy and Materials. Technology and Healthcare also contributed to the relative underperformance. Although the composite underperformed its benchmark for the quarter, the S&P 500 Total Return Index ("S&P 500"), it is not designed to necessarily outperform it on an absolute basis. The strategy is designed to perform similar to the S&P 500 with lower volatility over an investment cycle. The whipsaw in October and risk-off market environment indicated by the Hanseatic Defensive Index prudently indicated for a higher cash position during October. Cash was increased as a result of several stocks violating the Hanseatic primary sell discipline and the lack of any new buy candidates. This whipsaw negatively impacted absolute performance as the market rebounded sharply in October, but it was the correct posture for this strategy.

Third Quarter 2014

  • The Large Cap Institutional Equity composite gained 0.25%, underperforming the Russell 1000 Growth benchmark by 1.24%.
  • The All Cap Growth Equity composite lost 4.23%, underperforming the Russell 3000 Growth benchmark by 5.13%.
  • The Mid Cap Equity composite lost 5.23%, underperforming the S&P 400 Total Return benchmark by 1.24%.
  • The Latin America Equity strategy lost 3.74%, outperforming the Russell Latin America benchmark by 2.28%.
  • The Growth & Income Equity composite lost 2.40%, underperforming the S&P 500 Total Return benchmark by 3.53%.

Hanseatic Market Commentary

September has historically been the worst month for the stock market, and indeed it has lived up to its negative expectations. The S&P 500 eked out a small gain for the third quarter, but volatility increased significantly in the last half of September as six out of the last eight trading days were negative. Although large cap stocks were narrowly positive for the quarter, mid cap and especially small cap stocks fared considerably worse; the Russell 2000 index finished the month down over 6% and the quarter down nearly 8%. Healthcare accounts for most of the current relative and absolute leadership among the ten market sectors, although some retailers within the Consumer Discretionary sector and the Financial sector in general have improved of late. The Energy sector is weak across the board. Inconsistent market sector and industry group behavior has persisted for most of 2014.

If investors are looking for reasons to sell stocks, the market risks and economic crosscurrents are manifest. The obvious ones are in the Mideast, in the Ukraine, and potentially in the Baltic and will be with us for a prolonged period. Hong Kong and Ebola are the latest causes for concern, but likely the most important uncertainty investors are trying to assess is whether economic growth will be strong enough to withstand higher interest rates. Now that the Fed is nearing the end of its monetary ease programs, the consensus view seems to be that they will begin to raise short term rates around mid-2015. Recent relatively positive economic reports might, under normal circumstances, move the timeline somewhat closer; however, one important factor that mitigates the risk of continuing accommodative policy is that inflation remains remarkably subdued, both domestically and globally. Large bets have been placed by hedge funds and others on the quite rational notion that the ultra-easy policies enacted by the Fed and other central banks would necessarily, at some point, translate to hyperinflation. Instead, both price inflation and wage inflation remain quite low and our primary concern is deflation. One potential cause of this seemingly irrational outcome might be that ultra-easy monetary policies induced more production capacity than demand in a low growth world. Globalization in general and the extraordinary pace of technology/productivity innovations also tend to be deflationary.

Two notable recent events are a resurgent U.S. dollar and sagging energy prices. The dollar is up almost 8% since July, rising in almost parabolic fashion. The move has been driven by the prospect of higher U.S. interest rates and domestic economic strength in contrast to the softening economies in Europe, Asia and the emerging world. The positive impacts of a stronger U.S. dollar include lower costs for imported goods and downward pressure on inflation and energy costs, but there are always pros and cons to significant currency shifts. Almost half of the S&P 500 earnings are international, and the strength in the U.S. dollar has already caused some forward earnings estimates by analysts to be reduced. Also, U.S. exports become marginally less competitive.

Crude oil prices have fallen to the lowest level in 17 months. When natural gas liquids are included, U.S. oil output is nearly even with Saudi Arabia. Also, unlike all the past episodes of Mideast turmoil, there is no current tangible threat to supplies. Meanwhile, Chinese oil demand isn’t as robust as expected and European economies are stagnant and unable to fully realize the benefit of lower energy prices because of the weak Euro. The one clear beneficiary of the energy situation is the U.S. consumer and economy.

Looking ahead for U.S. stocks, if September is the weakest month, October has earned a well-deserved reputation for being the most volatile month. Market volatility has already risen significantly over the last half of September. The bull market has entered a mature phase and will likely face some different headwinds if it can find a trading bottom in the weeks ahead and continue its advance into 2015. A major prerequisite for that scenario would be for the market to find renewed sector/industry leadership that alters the distributive character the market has taken on over the last several months. The liquidity from stock buybacks that has buoyed the market over the last couple years is unlikely to be sustained. The market must also contend with what is likely to be a secular change in the structure of the yield curve, whose positive slope is critical to the health of the equity market and the economy. Nonetheless, with the challenges the market likely faces duly noted, the most salient fact about the current market is that we remain in a secular bull market and probability for its continuation is quite favorable.

Second Quarter 2014

  • The Large Cap Institutional Equity composite gained 5.01%, underperforming the Russell 1000 Growth benchmark by 0.12%.
  • The All Cap Growth Equity composite gained 5.61%, outperforming the Russell 3000 Growth benchmark by 0.60%.
  • The Latin America Equity strategy gained 15.34%, outperforming the Russell Latin America benchmark by 8.66%.
  • The Growth & Income Equity composite gained 4.39%, underperforming the S&P 500 Total Return by 0.84%.

Hanseatic Market Commentary

As 2014 began, the conventional wisdom seemed to be that interest rates would necessarily be higher as the economy finally turned the corner after five years of tepid growth. Stock prices would also rise, but only modestly so, after a blockbuster 2013 had already discounted much of the anticipated improvement in corporate earnings. Now, at midyear, interest rates have instead declined about 50 bps on the benchmark U.S. Treasury Note and even more at the long end of the yield curve. The stock market has done its part; the S&P 500 rose 7% through June despite a 5% spring correction.

The economy started out dismally in the first quarter of 2014 as GDP growth was actually negative, but there was a very tangible excuse for this: weather. A historically cold and snowy winter in the U.S. disrupted retail supply chains and manufacturing. All manner of the retail trade was severely impacted. The only issue was to what degree and how quickly the economy would recover under normal conditions. As expected, the economy has rebounded over the last couple months, but the capstone report was today’s (7/3/14) news that 288,000 jobs were created in June and a fifth straight month of 200,000 or more jobs. The unemployment rate fell to 6.1%, the lowest since September 2008. As impressive as the top line number is, it is tempered by subdued wage inflation and a low labor participation rate.

The S&P 500 Index is now at historic highs, finally surpassing the 2007 peak. More important is the overall market environment which is a persistent, low volatility secular uptrend. Markets are seldom perfect, and even in this current healthy environment there are some non-confirmations which if they persist could be leading indicators of problems down the road. The first concern is the relative weakness in the Consumer Discretionary sector in general, and the Retailing and Homebuilding groups in particular. Second, if Industrials are a leading indicator of the global economy, things are less than optimal. Third is the slow recovery in small cap stocks which have lagged the large cap stocks by a substantial margin over the last few months. A potential catalyst for improved small cap Performance would be a more robust economic rebound as they tend to be more responsive to domestic economic conditions. A pickup in M&A activity would also be beneficial.

From a broader perspective, stock market valuations are moderately higher than historic norms as the rally over the past two years has largely been driven by rising valuations. There is complacency about the low interest rates/inflation and the stock market itself as suggested by the low Volatility Index (VIX) reading. The complacency is clearly aided and abetted by a very dovish Federal Reserve. These are cautionary observations, but not a trigger to be bearish. As legendary investor Peter Lynch has pointed out, far more money has been lost trying to avoid market downturns than in the downturns themselves.

First Quarter 2014

  • The Large Cap product gained 0.34%, underperforming the Russell 1000 Growth benchmark by 0.85%.
  • The All Cap Growth product gained 0.44%, underperforming the Russell 3000 Growth benchmark by 0.78%.
  • The Latin America Equity strategy lost 8.33%, underperforming the Russell Latin America benchmark by 8.38%.
  • The Growth & Income product gained 1.36%, underperforming the S&P 500 Total Return by 0.59%.

Hanseatic Market Commentary

Across the whole quarter, the first quarter of 2014 was a relatively tranquil period for the stock market. However, during the quarter, the S&P 500 (SPX) sustained a brief but sharp 5%+ correction over a few market days in late January – early February. The index recaptured that deficit and more, marking new all-time highs in early March. SPX was confined to a narrow trading range the remainder of March before an end of month rally left the index just shy of a new high.

The SPX’s behavior considerably belied the steeper corrections in many other market indices. Beneath the surface, there were two notable changes in market structure. First, the stocks that performed the best in 2013 suffered deep corrections over the last two weeks of March. Biotech and Internet/social media stocks were hit particularly hard. One catalyst for the biotech pullback was a headline story about a congressional inquiry into the pricing of Gilead Sciences’ (GILD) hepatitis drug. The reactive selling in GILD shares morphed into panic selling in the biotech sector. In total, the biotech sector declined by 10.60% and GILD declined by 14.41% during the month of March. It was largely a situation, in our view, where managers sold whatever issues had the largest gains, turning unrealized gains into realized gains for the end of the quarter. That process undoubtedly triggered trading stops, which begets a short-term environment in which fear trumps rational decision making.

The more intense selling was quite selective; the market did rotate to some degree into issues perceived to hold less risk, including outright defensive stocks. The key question is whether this preference for lower risk is another very short-term phenomenon or the onset of a risk-off environment that would likely coincide with a cyclical correction of greater magnitude than experienced over the last couple years. Based on the probabilities from our proprietary analytics, we assign favorable odds to the resumption of the secular uptrend.

Of more interest to us is whether the markets’ preference for growth stocks relative to value issues, a trend that has persisted since 2006, will moderate as the economy finally begins to accelerate. We give this a better chance of developing in the months ahead. Our process will adapt, as it did from 2000 – 2006, as this potential change occurs.